March’s 25bp hike is likely to be the last for this cycle as banking sector uncertainty tightens financial conditions and weighs on growth.
At their March meeting, the FOMC kept the immediate focus on the fight against inflation by hiking 25bps to a mid-point of 4.875% while also recognising the tightening of financial conditions to come as a result of this month’s Silicon Valley Bank and Signature Bank failures.
While uncertain in time and scale, the inclusion of “Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation” makes clear the Committee’s expectation that the cost to the economy from this crisis of confidence in US regional banks will prove significant.
The FOMC go on in the statement to note that “some additional policy firming may be appropriate”, a much more dovish forward view on monetary policy than February’s “ongoing increases in the target range will be appropriate”. Further highlighting the significance of the change in circumstances, the press conference consequently made clear that these views are held by the FOMC despite Inflation being too high and recent data stronger than expected.
The immediate outlook for US monetary policy is therefore uncertain. The FOMC could certainly justify hiking once more in May to a peak of 5.125%. However, given the risks around financial conditions and confidence, holding off to assess would be the more prudent course, particularly given policy is already contractionary and forward indicators for inflation and the labour market were pointing down ahead of this shock, while the impact of these recent developments in the banking system is likely to be substantial for credit availability and economic activity.
Accordingly, we confirm our view that the federal funds rate has now peaked for this tightening cycle.
We also confirm our view that the federal funds rate is likely to remain on hold through the remainder of 2023. Apparent in the FOMC’s projections, and our own forecasts, is a need to keep policy on hold at a contractionary level for an extended period as inflation pressures abate and labour market slack increases. This is necessary to make sure the return to target inflation we forecast for late-2023 is sustainable. It is only once this goal is achieved that policy can be eased.
In contrast to current market pricing which sees 3-4 rate cuts by January 2024, Westpac anticipates rate cuts will not begin until March 2024. It appears that the Committee’s own expectation for policy is similarly timed to ours, with the median forecast of 5.1% at end-2023 followed by 80bps of cuts to end-2024 (surprisingly revised down from 100bps at the December meeting).
The cumulative scale of rate cuts from 2024 will clearly be dictated not only by the persistence of inflation, but also the cost to growth of contractionary monetary policy and banking sector uncertainty. We expect the loss of momentum to be more material in late-2023 than forecast by the FOMC (i.e. annual growth at December 2023 at or below zero versus the FOMC’s 0.4% median), and so anticipate a more aggressive pace of policy easing in 2024 than the Committee (200bps in 2024 from 4.875% versus 80bps from 5.1%).
This abrupt change in the stance of policy should create a robust turn in growth, allowing the FOMC to end the easing cycle in mid-2025 at a neutral level of 2.125%, well ahead of their timing (the FOMC’s end-2025 median forecast is 3.1%) but only marginally below the Committee’s longer-run estimate of 2.5%.
It is important to emphasise, as Chair Powell did in the press conference, that there are now multiple financial condition dynamics to assess in real time, each with their own timeline and risk profile. While term interest rates have fallen sharply, the 10-year yield from a recent peak of 4.06% to 3.50% currently, the economy is unlikely to receive benefit outside of a possible repricing of equities given the uncertainty surrounding the banking system, particularly the regional banks.
As the FOMC goes on hold, then begins to cut in 2024, term interest rates will fall further and general uncertainty over the health of the banking sector should subside; but a tighter regulatory focus on regional banks with less than $250bn in assets (which, until now, have had less onerous requirements) will likely continue to constrain lending and consequently investment and employment.
It is only after the regulatory regime is reset and confidence fully restored that easier policy will bring growth back above trend on a sustainable basis. This is unlikely before late-2024, at the earliest.
